Feature

Are REITs the Right Choice?

REITs are all the rave these days, with everything from billboard companies to casinos seeking to hop on board. But there are other ways to get income—with less risk. Consider Sun Communities and Retail Opportunity Investments—and also Honeywell and Merck.

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Prisons, casinos, and billboards have something in common. Companies that own these things have recently declared themselves real-estate investment trusts, or are pushing toward doing so.

REITs make money by renting property or collecting mortgage interest. They avoid corporate taxes so long as they pass 90% of their income on to investors as dividends. Companies that have recently announced REIT conversions have enjoyed average stock gains of 7% over 30 days, according to an analysis by Green Street Advisors, a REIT research firm.

To some, the string of REIT conversions looks like a tax dodge that Congress will eventually have to stop. Market veterans may recall that Congress in 1987 narrowed the definition of master limited partnerships, a pass-through structure favored by oil and gas pipelines, shortly after the Boston Celtics basketball team and other unlikely candidates became MLPs. There's a more recent case study to the north. In the early 2000s, a rush of Canadian companies converted to income trusts, that country's version of REITs. Share prices rose 10% to 20%. In 2006, the government cracked down, causing income trusts to effectively be taxed like ordinary companies. An index of income trusts plunged nearly 20% in two weeks.

While some argue that there could be a U.S. regulatory backlash if companies here stretch the REIT definition too far, that risk may be overstated, not least because the tax savings for REIT conversions aren't quite as large as they appear. But investors should view the conversion trend cautiously just the same. The abundance of companies wanting to be REITs is a signal that they have become too popular among investors. Valuations look rich, so buyers should be choosy. There are some good deals to be found among smaller REITs, but investors can do just as well with ordinary companies that pay good dividends.

THE REIT STRUCTURE was created in 1960 as a way to turn commercial real estate from a rich man's game into something available to anyone who could afford a few shares. Real estate was loosely defined as land and fixed improvements. Lawmakers then couldn't have foreseen even some of the noncontroversial REIT holdings today, including cellphone towers and data centers. To become a REIT, a company must have at least 75% of its assets in real property or mortgages and collect 75% of its income from the same. Companies that don't meet that definition can spin off real-estate assets as a REIT, or perform an "opco-propco" split, where the operating company and its assets are separated from the property.

THE FIRST SIGN THAT REIT conversions aren't a newly discovered tax dodge, then, is that they're not newly discovered. The second is that the tax savings for corporations are offset by higher taxes to investors. REITs must pay out nearly everything they make, and their dividends aren't taxed as dividends, which are currently capped at a preferential 20% rate, plus a 3.8% Medicare surtax for high earners. They're taxed as ordinary income, with rates up to 39.6%. REIT industry groups say the higher personal taxes make up for the lost corporate taxes. That seems a stretch, but it's difficult to calculate the precise tax trade-off because shareholders face varied tax rates, and some hold REIT shares in tax-deferred retirement accounts.

In theory, REITs could get caught up in an overhaul of the corporate tax code. If Congress lowered the rates and removed loopholes—and if it viewed REITs as one of those loopholes—share prices could take a hit. But that's not a near-term likelihood, considering how polarized the current Congress is. In any case, a change to REIT rules could easily grandfather in existing REITs, making them even more valuable in the eyes of investors.

Here's the larger risk for investors: Ultralow bond yields have sent investors scrambling for income, and REITs have become a favorite holding. The Vanguard REIT Index (VNQ) exchange-traded fund has gained 23% over two years, versus 19% for the S&P 500. Valuations look stretched. REITs in the S&P 500 recently traded at 20 times this year's projected funds from operations, the real-estate version of earnings. The broader S&P 500, in comparison, trades at 15 times earnings. As share prices rise, dividend yields fall. Vanguard REIT now yields 2.8%. Meanwhile, non-REIT companies are competing for income investors. S&P 500 companies are spending 37% of their earnings on dividends, up from 29% two years ago. The index's average dividend payer yields 2.3%, and about 100 companies yield 3% or more.

AS FOR THE NEWCOMERS to the category, there's nothing special about REIT status that makes companies better performers. "Storage and health care have done well as REITs, but I'm not sure about prisons and billboards," says David Harris, who covers REITs for Imperial Capital.